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Computer models in the energy sector, part three: market exploitation of the option value of generating plants

Computer models in the energy sector, part three

Baseload power plants are increasingly exiting the market.

Per Areskär

Partner, Financial Risk Management

KPMG i Sverige


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Dekorbild: Computer models in the energy sector, part three: market exploitation of the option value of generating plants

Baseload power plants are increasingly exiting the market, there will be no new nuclear plants from 2022, no new coal-fired power plants from 2038 at the latest... This means that natural gas plants are back in focus, after having spent recent years in something of a deep sleep due to their high short-term marginal costs. Exploiting these flexible power plants optimally is considerably more challenging than exploiting a brown coal plant, which runs continuously because of its technical setup. Natural gas power plants produce electricity depending directly on the electricity price, so you can consider them in financial terms as an option. Exploiting these power plants offers additional revenue potential that goes beyond the purely scheduled price and that can be leveraged risk-free using suitable strategies.

A quick look at the spot market price shows that the electricity price fluctuates – a lot

Often by EUR 20 to 30/MWh in one day, on an average price of EUR 50/MWh. This makes the electricity price fundamentally different from other commodity prices. This is down to the technical necessity for generation and consumption to be in balance at every second of the day, although almost all electricity generation plants and consumers cannot be determined precisely down to the second. Therefore, expensive, flexible means of storage, peak demand power plants and other network-support facilities must ensure that discrepancies are avoided. The great variation in the short-term marginal costs of the plants results in the massive price fluctuations already noted.

These fluctuations are an absolutely decisive factor for the exploitation of controllable generating plants. As warrant theory shows: high volatility means higher market value. Indirectly, high volatility in electricity prices means that flexible power plants can generate additional margins in exploiting futures, which can be interpreted as market value.

In financial theory terms, a controllable power plant is a call option with the following, simplified payout function: there is no payout below the short-term marginal costs, while above the short-term marginal costs the payout is the difference between electricity price and fuel costs. This payout function, and particularly the market value of the power plant in practice, can be modelled only using Monte Carlo simulation. With this technique, the optimal exploitation of the power plant is simulated for different price movements and the payout determined for each of these scenarios. The market value in this case depends on the lead time for exploitation, i.e. the duration of the option, the volatility of the electricity price and how sensitive the margin is to price fluctuations.

The market for electricity options continues to have scarce liquidity

Unfortunately, the market for electricity options continues to have scarce liquidity, so the market value of a power plant cannot be directly exploited by selling a suitable call option. So how can we realise the market value of a power plant? With traditional options, there is no optimal time of execution; similarly, there is no optimal time to exploit a power plant. However, the exploitation of a power plant can be adjusted risk-free to movements in the market, thus generating an additional margin that can be interpreted as part of the market value.

To do this, one needs to bear in mind how exploiting futures works for a power plant. On the futures market, only fixed volumes can be traded, in the simplest case annual fixed volumes [Bänder]. Fixed volume [Band] in this case means that the seller must deliver a constant output, i.e. the same volume of energy at every hour. If a fully flexible power plant is not in the money all hours of a day, then optimally it should not be running all hours. Therefore, the complete output would not be exploited, just the portion that corresponds to optimal deployment. If the average daily price now increases, this portion increases with it; if the price falls, the portion falls. Through this fluctuation additional margin can be generated using a suitable strategy.

The exploitation necessary for this is based on a value-neutral hedge of the power plant deployment simulated using an hourly price forward curve. For a power plant that is close to being at the money, this results in a percentage rate being exploited that corresponds roughly to those hours in which the power plant is in the money. Specifically, this means that for a power plant with short-term marginal costs of EUR 40/MWh and an average assumed electricity price of EUR 45/MWh, the power plant will run around 5000 hours out of 8760 hours per year. This is because the spread of the electricity price results in approx. 4000 hours showing an electricity price of less than EUR 40/MWh and a fully flexible power plant not being operated in these hours. If the forward electricity price develops negatively over time, the power plant will run for a shorter time, e.g. only 3000 hours. Exploitation would be adjusted accordingly, and only 2000 hours would be bought back. Buying back these hours generates a positive contribution margin, as the hours were sold at EUR 45/MWh and bought back at EUR 35/MWh. Assuming an exploitation horizon of three years, such fluctuations can occur multiple times and additional margins can thus be raised through continuous adjustment of the value-neutral hedge. Of course, there are limitations to this, mainly due to transaction costs, which mean that adjusting the hedge can generate a positive margin starting from a minimum price difference. Furthermore, this type of exploitation does not fit with the typically practiced exploitation over a continuous ramp-up.

This hedging strategy for thermal power plants means continually selling the production of one year in the three preceding years. As a result an average price is formed over this period. However, this strategy contradicts the delta hedging strategy described above, as the delta hedging strategy means that the entire planned production volume is already sold at the initial time three years before delivery and adjustments based on price fluctuations are only made thereafter. The drawback to this variant is that one sets a scheduled price early on, so only limited gains can be attained from subsequent market movements. The delta hedging strategy can also be combined with a continuous ramp up, though this means a reduction in the potential margin arising from the market value, as only a small volume is available for adjustments.

Optimisation of exploiting futures

All in all, the optimisation of exploiting futures for a flexible power plant represents an increasingly important component of the value chain. However, whether the strategy described is viable strongly depends on the power plant. Alternative options of power plant exploitation must also be taken into account; for example, could it currently be more lucrative to use a power plant for secondary reserve output or to deploy within a virtual power plant? However, the market is changing constantly and the options of exploiting futures should not be underestimated.

© 2021 KPMG AB, a Swedish Aktiebolag and a member firm of the KPMG global organization of independent member firms affiliated with KPMG International Limited, a private English company limited by guarantee. All rights reserved.


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